Moves to Make Before the Next FOMC Meeting

[1]The decisions made at the next Federal Open Market Committee meeting on Sept. 20-21 could affect market performance for years to come.

That’s why investors should prepare ahead of time.

Of course, there’s no way to predict exactly what U.S. Federal Reserve Chairman Ben Bernanke will do, but 20 years of experience in global markets suggest he’s considering five alternatives drawn from a rapidly diminishing menu of options:

Eliminate interest paid on reserves.

Sell short-term securities while buying longer-term debt.

Target actual inflation.

Buy more assets outright in a program that would be somewhat like the $600 billion worth of Treasuries it bought as part of QE2.

And, finally, it could just do nothing.

That being said, I have a pretty good idea which one of these options Bernanke will choose. But more importantly, I can tell you three moves you can make now to safeguard your investments ahead of time.

Let’s look at the Fed’s options first:

Option #1

First, the Fed could eliminate interest paid on reserves. Banks would hate this, but it would go a long way toward encouraging lending.

Banks right now are borrowing at extremely low rates, building up huge cash stockpiles and investing the spread. By doing this, the banks are earning more than they would from even their best customers at a fraction of the risk.

Customers have become almost irrelevant as a result, which is something our leaders cannot seem to grasp. So while they’re ostensibly all about helping Main Street, they’re really just selling out to Wall Street.

We have to get the money to the consumer where it can be used to create wealth.

Option #2

The second solution is to sell short-term securities while buying longer-term debt[2]. You might recall that the Fed did this in 1961 as part of something they called “Operation Twist.”

The goal at the time was twofold:

To flatten out the yield curve, or “twist” it so companies would have little choice but to begin investing the capital they were hoarding.

And to raise short-term rates as a means of attracting foreign investment to the United States.

That program met with some success, so we could be in for a reprise of sorts.

Option #3

The third option is to target inflation — and I don’t mean the “cooked” version, the core consumer price index that excludes food and energy prices. I mean the very real, everyday inflation the average person sees in the grocery store and at the gas station.

The Fed is acutely aware that its data doesn’t reflect the pain most consumers feel in their wallets[3]. Yet it continues to assert that inflation is “transitory[4],” despite an overwhelming mountain of evidence. And that’s detrimental to our financial markets.

Option #4

The fourth option would be for the Fed to buy more assets outright in a program similar to the $600 billion worth of Treasuries it bought as part of QE2[5].

At some point, reality is going to set in and the Fed is going to have to ask how much is enough. We’ve spent $600 billion and gotten squat in return. At the same time, this option creates another issue — it would put downward pressure on medium- and long-term rates for some period of time, depending on how much money is thrown at the problem. I’m not sure we could go lower than zero.

Naturally, this “solution” would be predicated on the assumption that growth eventually will return to bail us out. And its primary side effect would be further evisceration of our dollar[6].

Option #5

Finally, the Fed could simply do nothing.

As much as I disagree with Bernanke on most matters, he’s held his tongue most recently regarding further stimulative action. This suggests that he might be gaining some political backbone.

I respect that because the “all gain no pain” programs he’s undertaken so far have clearly been put in place to appease his political masters. The optimist in me wants to believe he’s going to say it’s time to take your medicine and let the markets sort this out. The pessimist in me says he’ll cave.

So which one option should the FOMC choose?

Option #5 — do nothing — would be best. That means no further accommodative measures should be implemented, or even hinted at.

The markets would tank — hard. But that would be a part of the healing process. The markets must be permitted to weed out the weaker players and eliminate those that aren’t strong enough to survive.

By engaging in repeated bailouts and stimulus, the Fed and our leaders in Washington are tying the free hand of risk. That limits our downside, but it also dramatically limits our upside, preventing a true recovery. It also goes against the very notion of capitalism, which includes failure.

Of course, to do nothing might be the best option, but we all know our policymakers don’t base their decisions on logic — they base them on political expedience.

To that end, doing nothing is an almost impossible call for most of our leaders to make, since they are more concerned with getting reelected than they are with solving problems.

That’s why I believe the Fed ultimately will choose to pursue Option #2 — some form of “Operation Twist.”

It probably will work for a short while, but then it’ll be business as usual. The problems of soaring debt, a lack of leadership, stagflation and a crushed middle class will re-emerge and weigh down the markets once again.

So where does that leave investors?

Moves to Make Before the Next FOMC Meeting

Don’t get caught in the middle, and don’t have any illusions about the Fed’s actions. The data is almost entirely negative, and with more than $202 trillion in unfunded liabilities that Washington lacks the willpower to address, anything the Fed does will be an exercise in the law of diminishing returns and unintended consequences.

Your best choices right now are to remain with those investments the government cannot abrogate or duplicate:

When it comes to stocks, stick to the “glocals.[7]” These are large multinational firms with diversified cash flows, fortress-like balance sheets and globally recognized brands.

Buy up resources, energy and other commodities[8] that will hold their value as the dollar declines. The most obvious play here is the SPDR Gold Trust (NYSE:GLD[9]). I am hesitant to chase anything that has gone up so rapidly, so pull backs may be your best bet at this stage of the game.

And use inverse funds, such as the Rydex Inverse S&P 500 Fund (MUTF:RYURX[10]), to hedge your downside and your income. The volatility that has recently entered the picture is likely to be our travelling companion for the foreseeable future.